Legacy liabilities in Canadian restructurings

May 2013 | LEGAL & REGULATORY | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

May 2013 Issue

Legacy liabilities have become an increasingly important concern for insolvency practitioners. The ability to restructure companies and carve out the valuable revenue producing assets which generate positive cash flow and continued employment without the noose of legacy liabilities that strangles growth is one of the goals of restructuring law. It requires a balancing of various interests in society with a focus on maintaining and creating wealth, growth and sustainability. It can be seen as a wedge between free market capitalism and societal concerns about historical environmental contamination or pension claims that arise as a result of private pension funds being eroded due to bad investments, low interests rates and longer life expectancies. While dealing with environmental and pension claims in a balanced way is an objective of a progressive democratic society, the issue that needs to be addressed is who should bear the cost, especially where they are decades old and do not relate to the ongoing business of the company, and the debtor is insolvent and has no means to pay or deal with those legacy liabilities.

Recently, the Supreme Court of Canada addressed these issues in relation to orders issued by environmental regulators requiring the remediation of contaminated property, and in respect of the scope and priority of pension claims in Ontario for defined benefit pension plans in insolvency proceedings. A review of the Supreme Court of Canada’s decisions provide guidance and an outline of how the courts may interpret the effect of orders made by environmental regulators and the scope of and priority of pension claims in insolvency situations. While there are still many questions that remain unanswered, these decisions have brought some clarity as to how the courts will adjudicate these claims, and how insolvency practitioners can therefore advise stakeholders to protect their relative interests when a debtor runs into financial trouble and seeks protection under Canadian insolvency law to allow it to try to preserve its business and shed its legacy liabilities.

In one of these cases, the Supreme Court of Canada held that orders issued by environmental regulators requiring the remediation of contaminated property can, if certain criteria are met, be characterised as monetary claims, and those claims can be subject to compromise in insolvency proceedings. This decision has important implications for commercial lenders, restructuring companies and stakeholders of companies that have historical environmental liabilities.

The majority opinion of the Supreme Court of Canada articulated a three-prong test to determine whether an environmental regulatory order constitutes a monetary claim that may be compromised under the CCAA, as follows: (i) there must be a debt, liability or obligation to a creditor; (ii) such debt, liability or obligation must have arisen prior to the time limit for inclusion in the CCAA claims process; and (iii) it must be possible to attach a monetary value to the debt, liability or obligation. In addition, the factual matrix to be considered in determining whether an order is a claim that can be compromised under the CCAA includes whether the debtor has the means to comply with such order and the effect that requiring the debtor to comply with the order would have on the CCAA process.

Applying that test, the court found that the first two prongs were easily satisfied: first, an obligation was due to the province, as a creditor, because the province had resorted to enforcement mechanisms. Second, the environmental damage clearly occurred before the commencement of the CCAA proceedings. Thus, the case turned on the third prong of the test – whether it was possible to attach a monetary value to the obligation owed by the debtor to the province to remediate the contaminated properties. The Supreme Court’s focus, therefore, was on whether orders not expressed in monetary terms can be characterised in those terms.

The court noted that the province’s claim against the debtor was ‘contingent’ to the extent that the province had not commenced any remediation activities or formally exercised its power to ask for the payment of money from debtor. The test used by courts to determine whether a contingent claim can be included in an insolvency process and compromised is whether the event that has not yet occurred is too remote or speculative. Applying that test, it was held that monetary value attaches to a claim – and a debtor’s obligations pursuant to a regulatory order can be compromised under the CCAA – as long as it is ‘sufficiently certain’ that the regulatory body will perform remediation work and be in a position to assert a monetary claim against the debtor.

In responding to various policy arguments as to why the environmental orders should not be compromised pursuant to the CCAA claims process, it was held that subjecting environmental orders to the CCAA claims process simply means that the claim will be paid according to the payment and priority regime established by the applicable insolvency legislation. It does not extinguish a debtor’s environmental obligations any more than subjecting any creditor’s claim to the process extinguishes a debtor’s obligation to pay its debts. In addition, making the debtor’s estate pay to remediate environmental claims that are actually monetary in nature would shift the burden of paying for such remediation to the debtor’s third-party creditors, who were not responsible for the contamination of the properties. Also, compromising the province’s claims would not give debtors a ‘licence to pollute’ because insolvency proceedings do not affect a debtor’s future conduct and reorganised debtors must comply with all environmental regulations going forward. Finally, because corporate restructurings under insolvency legislation are ‘hardly ever a deliberate choice’, compromising regulatory orders will not incentivise corporations to restructure simply to avoid their environmental liabilities.

The CCAA provides that environmental regulators have a super-priority claim for remediation costs secured by a charge on the contaminated real property and contiguous property that is ‘related to’ the activity that caused the contamination and does not extend to the totality of the debtor’s assets. This evidences a balance struck by parliament between the public’s interest in enforcing environmental regulations against the contaminated real property alone and the interests of third-party creditors with claims against the totality of the debtor’s assets.

The decision confirms that if environmental damage occurs before the commencement of a CCAA proceeding and a regulatory body issues a remediation order but has no realistic alternative other than performing the remediation work itself, such an order will almost certainly constitute a claim that can become subject to the claims process. Otherwise, regulatory agencies would be able to create a priority claim – at the expense of the debtor’s other creditors – by delaying the commencement of remediation work and arguing that they do not have a monetary claim because they are not yet creditors.

The Supreme Court’s framework for considering and assessing environmental claims will provide helpful and constructive guidance to lower courts as well as greater comfort to secured lenders –including DIP lenders – and insolvent companies with environmental contamination issues. That decision also reaffirms that the CCAA and claims processes issued thereunder are meant to ensure fairness between creditors, finality in the insolvency process and, in the restructuring context, an opportunity for the debtor to make as fresh a start as possible once its plan of promise or arrangement is approved.

The Supreme Court of Canada also recently released a decision regarding the priority and scope of pension claims in insolvencies. The court held that the deemed trust (akin to a statutory security interest) created by the Pension Benefits Act (Ontario) (PBA) extends to the obligation of a pension plan sponsor to fund the pension wind-up deficiency on the wind-up of a DB pension plan. The deemed trust does not arise unless and until the pension plan is wound up. Outside of a bankruptcy – a liquidation proceeding under the Bankruptcy and Insolvency Act (Canada) (BIA) – the Personal Property Security Act (Ontario) (PPSA) provides that the deemed trust has priority over a security interest granted by the debtor company in inventory and receivables. The deemed trust also takes priority over unsecured debt, again outside of a bankruptcy.

However, the court also held that a court supervising a CCAA proceeding has authority to grant a DIP charge that has priority over the deemed trust created by the PBA. The court concluded that to the extent valid orders issued under the federal CCAA conflict with the provisions of the provincial PBA and PPSA, the orders under the federal legislation take precedence as a result of the doctrine of federal paramountcy.

The issue initially brought before the CCAA Court can be stated succinctly: the debtor had an obligation to repay its DIP financing from the proceeds generated from the sale of its assets in the CCAA proceeding. It also had an obligation to fund the wind-up deficiencies in its pension plans in accordance with the provisions of the PBA. It had insufficient proceeds to do both. The question before the CCAA court was which obligation had priority. The CCAA court concluded that the DIP charge had priority.

This decision is a mixed result for commercial lenders and debtor companies with underfunded DB pension plans that need secure and stable access to commercial capital. Depending on the extent of the estimated wind-up deficiency, a debtor’s access to financing outside a DIP context may be severely constrained or even eliminated. Even if the risk of the priority deemed trust is manageable, lenders may still require credit enhancements; increased financial diligence; greater and more frequent reporting requirements and pension plan actuarial valuations; a host of more restrictive covenants in credit agreements; the taking of additional reserves against loan advances; and increased pricing to reflect the greater risk associated with lending to companies with large unfunded pension wind-up deficiencies.

The deemed trust priority is not operative in a BIA liquidation. Therefore lenders may consider their ability, upon a default, to seek to have the debtor adjudged bankrupt. It was held that it is not a breach of fiduciary duty for a debtor that is also a pension plan administrator to bring a motion in a CCAA case to seek authority to assign itself into bankruptcy, as long as the conflict is addressed, primarily by providing an opportunity for the pension beneficiaries to have their interests meaningfully represented.

Unfortunately, this decision has resulted in material risks for commercial lenders (whether secured or unsecured) to debtors with underfunded DB pension plans, as well as governance challenges for sponsors and administrators of pension plans. How these risks can be managed remains to be seen. On the other hand, the decision does provide needed certainty which will facilitate DIP financing in Canada. The Supreme Court concluded that the court-ordered DIP charge had priority over the PBA deemed trust. No commercially motivated lender could be expected to advance funds without the priority afforded by the DIP charge. The Supreme Court recognised this reality and, in doing so, supported the stability, certainty and predictability that are vital for the financing of a successful CCAA restructuring.

Steven Weisz and Linc Rogers are partners, and Marc Flynn is an associate, at Blake, Cassels & Graydon LLP. Mr Weisz can be contacted on +1 (416) 863 2616 or by email: steven.weisz@blakes.com. Mr Rogers can be contacted on +1 (416) 863 4168 or by email: linc.rogers@blakes.com. Mr Flynn can be contacted on +1 (416) 863 2685 or by email: marc.flynn@blakes.com.